Buffett BofA buy no seal of approval

The lead news story across America on Friday was Warren Buffett’s $5-billion investment in Bank of America. Bank of America’s value has been plummeting on concerns about its ability to raise the necessary capital to continue business in the face of a massive litigation and regulatory burden, a crushing portfolio of poorly performing assets and costly acquisitions of under-performing companies — particularly Countrywide.

Buffett’s investment surprised many market watchers because Bank of America — like many other giant U.S. banks — is in no better shape now than during the financial crisis of 2007 and 2008. Not only do massive toxic assets still remain on their balance sheets, which they’re working off over time, but the Dodd-Frank Act now requires that banks maintain higher capital levels than ever before. These new requirements actually discourage banks from cleaning up balances — because purging bad assets means write-downs that make it harder to meet the new capital levels.

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The question that everyone is now asking is what Buffett’s investment tells us about the state of the U.S. financial system.

Certainly the Obama administration wants to assert that Buffett’s investment means that giant financial institutions — like Bank of America and Citigroup — have finally turned the corner. This interpretation would bode well for the economy.

Because these behemoth institutions are both considered “systemically important,” as well as “too big to fail,” Buffett’s investment might also indicate that the government is finally out of the bailout business. It won’t have to inject funds to keep these large financial institutions going if private sector players — like Buffett’s Berkshire Hathaway — are willing to provide these companies with the capital they require to stay in business.

Unfortunately, while Buffett’s $5 billion likely was a savvy investment from the billionaire’s point of view, it doesn’t tell us much, if anything, about the financial health of the nation’s biggest banks. In fact, on closer analysis, what little it does tell us is discouraging.

Buffett’s investment likely signals not that he is confident that Bank of America is a good bet, but rather that he is confident that the government will again step in and bailout the bank if his bet turns out to be a bad one.

To understand why, it’s important to know that Berkshire Hathaway is not buying the regular, so-called “common” stock available to ordinary investors. Instead Bank of America is to issue Buffett 50,000 preferred shares, for which Berkshire Hathaway is paying $100,000 each.

Unlike the paltry returns available to most other investors these days, Bank of America is promising to pay Buffett’s investment a whopping annual dividend of 6 percent to be paid out quarterly.